Cash flows are the net amount of cash and cash-equivalents that is being transferred into and out of a business. They give a snapshot of the company’s liquidity position i.e. the amount of cash coming into the business, the source of cash, and the amount flowing out. While the ultimate measure of a company’s success is the extent to which cash flows enriches shareholders values, it is unforeseen that positive cash flows is the predominant drive to maximizing shareholder values.
As the saying goes, “Cash is king. Get every drop of cash you can get and hold on to it”. Let’s think of it as a water tank: water comes in at the top and drains out the bottom. To maintain a full tank, you’ll definitely need more coming in than going out.
Importance of Cash Flows
Inflow of cash comes from customers who purchase your company’s business’ products or services. When sold on credit, the cash flows will then derive from collections of accounts receivable. On the other hand, outflow of cash leaves your business as a result of debt obligations. Choosing to pay over credit terms instead of paying in cash will be recorded as accounts payable in the balance sheet.
When more money is coming in than it is going out, you are in a “positive cash flows” situation where closing balance is higher than opening balance; you have enough to pay your bills. If more cash is going out than coming in, you are in danger of being overdrawn, and you will need to find money to cover your overdrafts. Therefore, businesses which need working capital tend to approach alternative financiers to obtain funding to cover shortages in cash flows.
How to analyse Cash Flows?
Running a cash flow statement will give your company an overview of the cash flow position i.e. how well the company generates cash to pay its debt obligations and fund its operating expenses.
The statement of cash flow is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents. It breaks down the analysis to operating, investing and financing activities.[
This is an effective measure of strength, profitability and the long-term outlook for a company. For investors, the cash flow statement reflects a company’s financial health. The more cash that is available for business operations, the better it is; meaning safer for them to onboard investments in such a company with positive cash flows. However, this should not be taken as the general rule of thumb.
Cash Flows VS Profits (Revenue)
A company may seem profitable on the surface but in actuality, do not have cash. This is because profits are computed using revenues and expenses, which are different from the company’s cash receipts and cash disbursements. How is that so?
Accounts receivable is the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. A company may have the assets recorded in the balance sheet, but if the payment for goods & services provided has not been collected, there will not be cash.
Turn Invoice into Cash
Also, businesses who run on accrual accounting tend to recognize income at the point where an invoice is sent, even though the customer hasn’t paid. In this case, the company “earned” profits but not cash.